The Economics of Counterfeiting∗
Elena Quercioli†
Economics Department
Tulane University
Lones Smith‡
Economics Department
University of Michigan
January 10, 2009
Abstract
This paper develops a new tractable strategic theory of counterfeiting as a
competition between good and bad guys. There is free entry of bad guys, who
choose whether and what note to counterfeit, and what quality to produce. Good
guys select a costly verification effort. Along with the quality, this effort fixes
the chance of finding counterfeits, and induces a collateral “hot potato” passing
game among good guys — seeking to avoid counterfeits passed around. We find
a unique equilibrium of the entwined counterfeiting and verifying games. With
log-concave verification costs, counterfeiters producer better quality at higher
notes, but verifiers try sufficiently harder that the verification rate still rises. We
prove that the unobserved counterfeiting rate is hill-shaped in the note, vanishing
at extremes. We also deduce comparative statics in legal costs and the technology.
We find that the very stochastic nature of counterfeiting limits its social cost.
Our theory applies to fixed-value counterfeits, like checks, money orders, or
money. Focusing on counterfeit money, we assemble a unique data set from the
U.S. Secret Service. We identify key time series and cross-sectional patterns, and
explain them: (1) the ratio of all counterfeit money (seized or passed) to passed
money rises in the note, but less than proportionately; (2) the passed-circulation
ratio rises in the note, and is very small at $1 notes; (3) the vast majority of
counterfeit money used to be seized before circulation, but now most passes into
circulation; and (4) the share of passed money found by Federal Reserve Banks
generally falls in the note, as does the ratio of the internal FRB passed rate to the
economy-wide average. Our theory explains how to estimate from data both the
street price of counterfeit notes and the small costs of verifying counterfeit notes.
∗This paper has